Q4 Insights: How relative strength influences the market

4 September 2017

By Rodney Raanan

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The market moves fast. That’s a fact. With 11 sectors to watch, institutional investors have to decide which sectors are the strongest and which are the weakest. They must decide on where to put money to work (overweight position) and where to reduce exposure (underweight position) in order to beat a benchmark. To help make key investment decisions, Portfolio Managers rely on Relative Strength, an indicator designed to help investors compare the performance of a stock, exchange-traded fund (ETF) or mutual fund to that of the overall market. The top-down process often starts at the pinnacle of the GICs triangle, selecting a sector that is strongest, choosing an industry group, then deciding on specific equities to put money to work in.

To better understand the impact — and influence — of relative strength on investment decisions, let’s analyze 10 sector SPDR ETFs relative to the S&P 500, which include: Consumer Discretionary (XLY), Consumer Staples (XLP), Energy (XLE), Financials (XLF), Health Care (XLV), Industrials (XLI), Materials (XLB), Real Estate (XLRE), Technology (XLK-includes Telecommunications), and Utilities (XLU). The relative strength analysis allows us to see which sectors are outperforming, underperforming, and losing/gaining momentum over the last year. The slope of each line in the graph below tells us the direction of the trend.

Outperforming sectors include the XLF, XLK, and XLI. For instance, XLF began to significantly outperform all other sectors following the Presidential election due to hopes of deregulation and higher interest rates. Higher rates bode well for the banking sector as net interest margins will expand, in turn raising profitability. The XLK has also been a top performing sector and continues to build strength. Companies in the technology sector are disrupting the market, especially companies such as: Nvidia, Facebook, Apple, Alphabet (Google), and Microsoft. Additionally, this sector has proven resilient and represents long-term growth opportunities.

Comprised of aerospace and defense, industrial machinery, tools, lumber production, construction, waste management, manufactured housing, cement and metal fabrication, XLI is another sector that has performed nicely over the last 12 months. Strong performance from industrial stocks signal that we have demand for building construction and manufactured products. This sector is the third best performer in the last 12 months despite the largest weighted stock, General Electric, being a weak performer.

On the other end of the spectrum, XLE is the poorest performing sector through this period and continues to make new lows. Trend-following strategies argue for selling energy stocks in favor of stronger trends elsewhere in the market. Numerous independent studies, including a well documented one entitled Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency (Narasimhan Jegadeesh; Sheridan Titman) have found that the strong usually continue to get stronger and the weak usually get weaker (momentum persistence); therefore, investing with the trend is another common theme among many top-down Portfolio Managers.

Key findings from our analysis of relative strength in real time show: XLU, XLK, and XLV gaining momentum, while XLF is losing momentum. This could potentially be a sign that low yields are here to stay. We are now seeing money move from the XLF into sectors such as the XLU and XLRE which benefit from the drop-in yields. The move lower on the 10-year note is very surprising given that the Federal Reserve has been increasing rates. We put in a double top around 2.62 percent, failed on the move higher from 2.1-2.4 percent, and are now testing the 2.1 percent support level.

The upturn in the XLV’s strength is on the heels of Gilead’s acquisition of Kite Pharma. We are seeing different names across the biotech sector surge due to M&A hopes, making this an area that investors will watch closely. The XLK continues to move higher and saw a “buy the dip” scenario in early July when we saw a technology sell-off. This was immediately seen as a buying opportunity with money rushing back into the sector. Since the pullback, the XLK has been the strongest sector in the market. The falling slope in the XLP is also telling, indicating that institutional investors are more comfortable with a risk on trade as opposed to being risk averse.

* Data is of 9/1 market close.

Advantages for IROs & Market Intelligence

IROs can benefit from analyzing both relative strength and momentum in a number of ways. Here’s how:

Gain insight into a sector to see if it is gaining momentum or losing it.

Understand if an institutional investor is trying to accumulate an overweight or underweight position.

Have an edge in giving the C-level real-time money flows.

Understand how a stock is behaving relative to its peers.

Rodney Raanan is the Director of Capital Markets & Market Intelligence at Q4 Inc. Rodney works directly with C-level executives of publicly traded companies by providing real time money flows, stock activity updates, options analysis, and technical analysis. Rodney has over 10 years of capital markets experience as an equity trader and an analyst. Follow Rodney on Twitter and Linkedin.